August 31, 2010

Some more detail on the outlook for interest rates and inflation

Andrew Lilico is Policy Exchange's Chief Economist.

My previous blogpost attracted quite a bit of attention
(probably more than it deserved).Curiously, attention focused on those parts of the post in which I was
repeating opinions I’ve expressed since early 2009 (indeed, have argued in a
more general form since 2002, as for example here), and hence that I didn’t defend in any
detail.As a consequence, much of the
subsequent press discussion seems to me to have missed a number of important
points, which I propose to explore a little more now.

1)In
my view there are three broadly plausible paths for the UK economy from here over the next few years:
deflationary slump (let’s call this the “US
1930s” scenario); robust sustainable recovery (let’s call this the “UK 1990s” scenario); unsustainable nominal boom
followed by bust (let’s call this the “UK 1970s” scenario).The scenario I don’t consider plausible is
what we might call the “Japan
1990s” scenario — the scenario widely covered in the press and City circles, in
which the economy suffers an extended period of very low nominal growth, with
growth rates consistently at about 1% and enduring risk of deflation that never
quite materialises.

The reason I don’t consider this plausible is that I don’t believe it
could constitute an equilibrium.Specifically, Japan
was able to sustain this scenario in the 1990s because it entered the scenario
with very high levels of household savings.That meant that households were able to endure an extended period of low
growth with relatively little proximate impact — the Japanese losses were
mainly in output foregone (and of course lost asset valuations and huge rises
in government debt).

By contrast, the UK
entered the post-2007 crisis with very high levels of household
indebtedness.UK households have gambled on
obtaining very high levels of nominal wage growth in order to be able to
service their debts.Without that wage
growth, the burden of servicing those debts will start to drive widespread
defaulting, leading to a snowball effect driving down prices, triggering nominal
wage deflation, more rapid defaulting and further financial sector problems,
dragging the economy into the deflationary slump scenario (the US 1930s
scenario).Unless we want deflationary
slump, then there has to be nominal wage growth — simple stagnation is not an
option; our households are too heavily indebted to tough this out.(For more detail on UK household
indebtedness, see this report, especially Figure 2.)

The
near-term risk of falling into deflationary slump will become acute as we enter
double dip later this year or early 2011.But the monetary authorities have the power to prevent us falling into
deflationary slump: they can print more money (do more QE).That will be the correct response to double
dip.And even without a double dip, that
will be the correct policy to accompany the fierce fiscal tightening that is
planned (especially since the government has chosen to raise taxes (specifically
VAT) early in the tightening by more than I had hoped or recommended).

Quantitative
easing (QE), though it can certainly prevent deflation, is subject to what is
called the “ketchup-in-the-bottle” effect.In quantitative easing we expand what is called the “monetary base” —
the narrowest concept of the money supply.Now, there is a relationship between the monetary base and what really
counts for determining the level of nominal activity — broad money.Let’s call this relationship a “money
multiplier”.

In the medium term, that money multiplier must be determined by real
factors, such as the number of cashpoints in the economy, people’s habits for
the use of credit cards, and consequences such as the prudent level of
liquidity for banks to hold.In the
short term, however, the money multiplier can deviate very considerably from
its medium-term level.For example, if
households fear deflation, or if the banking sector is inadequately
capitalised, then the money multiplier can fall dramatically, but temporarily.

So when we use QE to try to offset deflationary pressures and financial
sector problems, we are raising the monetary base to try to maintain broad
money growth in a period in which the money multiplier is temporarily low.But then if we ultimately do enough to lead people to stop fearing
deflation and for the financial sector to recover, we should expect a
consequence to be that the money multiplier will snap back to its medium-term
equilibrium level — like ketchup surging out of a bottle when we finally hit it
hard enough, once enough money is finally printed the result will be a sudden
surge of broad money growth.Now, it
could well be that when there is a sufficiently severe financial crisis, even
the medium-term money multiplier falls — for example, the banking sector might
increase its view as to the prudent level of liquidity to hold.But even if that is true, it remains likely
that the medium-term money multiplier is higher than the short-term multiplier.

The consequence is that once enough QE is done, we should expect broad
money growth to begin to rise very rapidly — that will be a mark of
success.But the monetary authorities
cannot know what the new medium-term money multiplier is going to be, so it
will be simply impossible to calibrate withdrawal from QE precisely so as to
deliver the desired broad money growth on exit from crisis.Now of course the authorities will form estimates of the new
equilibrium level of the money multiplier.And they could use those
estimates to try to withdraw QE so as to avoid overshoot broad money growth on
exit.But is that a strategy that would
make any sense?I think clearly not,
because if they were to get their estimate wrong by over-estimating the new money multiplier, then they would withdraw
too much QE too early, and the consequence would be strong deflationary
pressure.If, say, a couple of quarters
into recovery in 2011 after a double dip we were to over-tighten and create
deflationary pressures, that could be disastrous.

The correct policy is to err on the side of too much broad money growth,
which we can mop up afterwards, tolerating a temporary
surge in inflation.Not because we want inflation, but because we cannot
accept deflation.

However,
contrary to certain overblown press reports, I’m not predicting anything that
could remotely be described as “hyper-inflation”.A CPI figure of over 6% is only marginally
above the 5.2% figure reached in September 2008.And a rise to 8% in interest rates to deal
with that (implying RPI exceeding 10% because of the rise in mortgage interest
payments) should not really be so unthinkable — only two years ago, interest
rates were 5.75% and heading up (indeed, a number of commentators were
predicting 7% interest rates even at that stage).In that sense, one way to think about my scenario
is as a return to the status quo ante
the crisis.

Indeed, if I am wrong and there is no double dip, then the next most
probable scenario is probably robust recovery, a la the UK in the
1990s.If that is what transpires, then
by 2012 we will be in the third year of robust recovery-driven growth, and
interest rates similar to those of 1996/7/8 (peaking in 1998 at 7.5%) should be
very much what one expects.The
“neutral” interest rate for the UK
is of the order of 5.5%.If we are in
the third year of boom by 2012, households should certainly be able to tolerate
interest rates higher than those of 2008 (after all, not many have taken out
new mortgages since 2008, and not many were bankrupted by the 5.75% interest
rates seen then).

(P.S. For what it’s worth, the
reports of 14% mortgage rates in some papers were nothing to do with me, and I
do not agree with that number — 8% interest rates are more likely to be
associated with 10% mortgage rates in my scenarios.)

Since
I’m not proposing that households will be expanding their consumption rapidly,
even in response to QE, where is the growth coming from?The answer is: investment.There are four key reasons why.

-The
first is extraordinarily low interest rates.I believe that, if there is a double dip, interest rates will stay very
low through 2011 even though growth will be robust for most of the year.Interest rates will be so low that investors
will be able to afford to have many projects go bad and yet still make
money.Very loose monetary policy can
stimulate investment very strongly, and investment flows can be very volatile —
capital formation grew 25% in the Heath-Barber boom from 1972Q1 to 1973Q1.

-The
second reason is that the credit crisis will come to an end.Europe Economics, as part of its analysis for Ofwat of the cost
of capital of the water industry (see p83ff), analyzed the progress of past periods of financial crises
(as it happens, I led the Europe Economics team).The analysis there suggested that periods of
elevation in corporate bond spreads in severe financial crises last around 4
years.So, given that the current crisis
began in 2007, we should expect corporate bond markets to decisively normalise
(as opposed to there being periods in which spreads fall but a continuous risk
of their spiking up again any time) in 2011.That means that the corporate sector should find it materially more
attractive to invest from mid-2011.

-Thirdly,
the corporate sector has already markedly reduced its leverage (with
non-financial corporation loans down from their 2008Q4 peak of nearly 25% of
GDP to 21% by 2010Q1), and by mid-2011 should be well-positioned to take on
more debt if opportunities arise, though it may prefer to issue new equity.

-Fourthly,
if I am correct to anticipate money-growth-driven inflation on exit from the
crisis, then investors will want to hold real assets.

As I
emphasized previously, there are huge uncertainties here.I do not pretend that my scenario is certain
to materialize — there could be deflationary slump; growth could be steadier
and more robust than I envisage, allowing earlier interest rate rises; the
inflationary spike could be much greater than I expect.Furthermore, it is perfectly possible that
the scenario I paint will
materialise, but will do so only a year or more later than I suggest —
forecasting both the scale of economic events and their timing is notoriously
difficult.But CPI and interest rates in
two years’ time only a percent or two higher than they were two years ago
should surely not be regarded as so unlikely as to be out-of-the-question and
the fact that a prediction that they could occur counts as front page news must
surely be an indication that we had previously lost our sense of perspective.

Comments

Some more detail on the outlook for interest rates and inflation

Andrew Lilico is Policy Exchange's Chief Economist.

My previous blogpost attracted quite a bit of attention
(probably more than it deserved).Curiously, attention focused on those parts of the post in which I was
repeating opinions I’ve expressed since early 2009 (indeed, have argued in a
more general form since 2002, as for example here), and hence that I didn’t defend in any
detail.As a consequence, much of the
subsequent press discussion seems to me to have missed a number of important
points, which I propose to explore a little more now.

1)In
my view there are three broadly plausible paths for the UK economy from here over the next few years:
deflationary slump (let’s call this the “US
1930s” scenario); robust sustainable recovery (let’s call this the “UK 1990s” scenario); unsustainable nominal boom
followed by bust (let’s call this the “UK 1970s” scenario).The scenario I don’t consider plausible is
what we might call the “Japan
1990s” scenario — the scenario widely covered in the press and City circles, in
which the economy suffers an extended period of very low nominal growth, with
growth rates consistently at about 1% and enduring risk of deflation that never
quite materialises.

The reason I don’t consider this plausible is that I don’t believe it
could constitute an equilibrium.Specifically, Japan
was able to sustain this scenario in the 1990s because it entered the scenario
with very high levels of household savings.That meant that households were able to endure an extended period of low
growth with relatively little proximate impact — the Japanese losses were
mainly in output foregone (and of course lost asset valuations and huge rises
in government debt).

By contrast, the UK
entered the post-2007 crisis with very high levels of household
indebtedness.UK households have gambled on
obtaining very high levels of nominal wage growth in order to be able to
service their debts.Without that wage
growth, the burden of servicing those debts will start to drive widespread
defaulting, leading to a snowball effect driving down prices, triggering nominal
wage deflation, more rapid defaulting and further financial sector problems,
dragging the economy into the deflationary slump scenario (the US 1930s
scenario).Unless we want deflationary
slump, then there has to be nominal wage growth — simple stagnation is not an
option; our households are too heavily indebted to tough this out.(For more detail on UK household
indebtedness, see this report, especially Figure 2.)